7/28/2006 @ 6:00PM

Beware The Stagflation Set Up

Stocks and bonds rallied as the U.S. Commerce Department reported slower-than-expected real gross domestic product growth. The “advance” estimate came in at only 2.5%, a significant decline from the 5.6% growth rate recorded in the first quarter, and well below the consensus expectation for 3% growth.

Investors cheered and poured money into stocks like
Advanced Micro Devices
,
Encore Wire
and
Intevac
, because slowing growth increases the odds that the U.S. Federal Reserve will stop raising interest rates.

But a careful read of the GDP report doesn’t provide much reason to celebrate. More than half the slowdown in overall growth was blamed on what looks like a significant slowdown in consumer spending. Personal consumption expenditures were up 4.8% in the first quarter but fell dramatically to only 2.5% in the second quarter, as consumers struggled with higher gasoline prices.

Furthermore, consumers spent less money on durable goods such as automobiles, and more money on necessary services such as medical care and utilities. Consumer spending is crucial for economic growth, because it accounts for 70% of our $12.5 trillion GDP. A decline in consumer spending (as opposed to a mere slowdown in growth) could throw the economy into recession.

Other factors contributing to the second-quarter economic slowdown include reduced spending by businesses on equipment and software, and a deceleration in exports. Many economists had predicted that business spending would make up for any slowdown in consumer spending. The evidence doesn’t support this thesis.

Of additional worry, the GDP report also raised red flags about inflation. Prices paid for domestic purchases increased 4.0%, after rising only 2.7% in the first quarter. Excluding food and energy, however, the 2.9% price increase is comparable with the first quarter’s 3.0% rise. Furthermore, disposable personal income increased 5.2% in the second quarter, as compared with only 3.8% in the first quarter. Yet after adjusting for the insidious effect of inflation on purchasing power, real disposable income climbed only 1.0%, down from 1.7% in the first quarter.

So the bottom line is that the economy is slowing, and inflation is rising. This doesn’t sound like much of a reason to celebrate. Based on today’s market reaction, investors are obviously betting that a slowing economy will bring inflation back under control. If they’re wrong about this, stagflation with mediocre growth and rising prices will be the inevitable outcome.